The Answer You've Been Waiting For

Fidelity answers Schwab with an even better deal for investors.

Discount brokers made the world of investing accessible even to those of modest means. Now, though, a price war has erupted in the brokerage industry, and it could have an even bigger impact on how you invest.

Back in November, Charles Schwab(NASDAQ:SCHW) announced that it would introduce exchange-traded funds of its own. Distinguishing Schwab's offerings from the hundreds of other ETFs available to investors was one appealing fact: The discount broker would offer its ETFs commission-free to those who had a Schwab brokerage account.

At the time, I predicted that the move would change the way you invest. Sensing the threat that Schwab posed to its own business model, Fidelity has responded with an even better offer for investors.

A dollar here, a dollar thereSet aside for the moment the fact that Fidelity is offering $7.95 trades for most stocks and ETFs, undercutting Schwab's $8.95 rate. Although existing Fidelity account holders will appreciate the reduction from commissions that were as high as $19.95, the $1 difference isn't likely to be big enough to encourage anyone to switch over from Schwab or any of Fidelity's other competitors.

What is a big deal, though, is the way Fidelity responded to Schwab's new ETFs. Instead of coming up with its own ETFs, Fidelity instead decided to allow its customers to buy and sell more than two dozen of the popular iShares ETF offerings at no commission. That move doesn't just give investors a better selection; it also resets the playing field among the major ETF providers.

A game-changerSchwab's ETFs weren't innovative in themselves. Although they have low expenses, they're mostly limited to asset classes that other ETFs already cover well. And because they're new, they don't have the recognition or the trading volume to attract outside investors. That in turn makes them less efficient for investors when they buy and sell the ETFs.

Fidelity, though, went with ETFs that have been around for years and already have billions in assets. In several cases, they're already at or near the top of their respective asset classes. Just take a look at some of the offerings that you can trade free:

ETF

Average Daily Trading Volume

Expense Ratio

Holdings Include ...

iShares Russell 2000 ETF (IWM)

$3.59 billion

0.2%

Human Genome Sciences(NASDAQ:HGSI), E*Trade Financial(NASDAQ:ETFC)

iShares MSCI EAFE (EFA)

$951 million

0.35%

BP(NYSE:BP), Novartis(NYSE:NVS)

iShares MSCI Emerging Markets (EEM)

$2.77 billion

0.72%

Petrobras(NYSE:PBR), China Mobile(NYSE:CHL)

Source: Yahoo! Finance.

In contrast, Schwab's ETFs are only seeing a few million dollars in volume daily. And unless they can pull in more assets and see their trading activity rise, those ETFs may well prove to be inferior alternatives to better-established funds like iShares -- even if the stated expense ratios for iShares are higher.

A wider selectionAnother advantage of Fidelity's iShares offerings is that they give investors a broader scope of different investments to choose from. The 25 ETFs Fidelity offers span the universe of small- and large-cap stocks, value and growth stocks, and domestic and international stocks.

What's next?Fidelity's move is just the next step in making ETFs more useful for small investors. Transaction costs make ETFs less attractive for those who regularly invest small amounts. But with no commissions to buy shares, even small investors can buy ETFs.

In addition, commission-free trading will greatly bolster iShares and its place among ETF providers. That explains why, when you look at Fidelity's disclosures, you'll notice that iShares is paying Fidelity in exchange for its marketing and commission waivers. ETF competitors like SPDRs, Vanguard, and PowerShares will likely need to find similar partners to promote their ETFs in order to maintain their competitive position.

As for the brokers, with two major industry players offering commission-free ETF trading, I'd expect to see the rest follow suit soon. That may not be great news for the brokers themselves, but it's a giant leap forward for their customers.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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